After reading yesterday’s lesson, you know what stocks and bonds are. You know people usually pick mutual funds such as index funds or ETFs to invest in inside their investment account.
Now what type of investment account does a person actually open? There are several types: 401k, 403b, TSP, Traditional IRA, Roth IRA, SEP IRA, Solo 401k, and taxable brokerage account.
People usually start investing in the stock market by utilizing accounts such as a traditional 401(k) and a Roth IRA. They do this, rather than a taxable brokerage account, because these accounts come with tax advantages.
401(k)
A 401k is an employer-sponsored retirement account where an employee can divert a portion of their paycheck into. It’s offered by corporations to employees. Usually, it’s done pre-tax (traditional 401k). A 401k plan gives employees a tax break because contributing pre-tax money into the account reduces their taxable income.
To entice employees to put money into the account (and because pensions are long gone for most people, R.I.P.), employers sometimes offer an “employer match” where they will match any contributions an employee makes.
This can be done in a variety of ways. Some examples:
- 100% employer match on the first 3% of pay
- 100% employer match on the first 3% of pay. 50% employer match on next 3% of pay.
- 80% employer match on first 6% of pay.
To encourage employees to remain with the company long-term, many workplace 401k plans have a vesting schedule. There are two types of vesting: cliff or graded.
Graded vesting is when an employee gradually gains ownership of employer match contributions in their 401k. You work at a company for several years in order to reach 100% vesting of employer match contributions.
It may look like being 20% vested after one year at the company. 40% vested after two years. 60% vested after three years. 80% vested after four years. 100% vested after five years. There is a max six year vesting limit in order to reach 100% vested.
Cliff vesting is less common and less appealing. There is no gradual vesting. You reach 100% vesting after a specific time frame, usually three years. Before then, you are 0% vested.
Writing about Graded vs. Cliff vesting in a workplace 401k makes me always think of those “I quit my job” stories. The ones where people announce they have left their job after a certain time and are pursuing something new. Did they wait until they were fully vested in their 401k before leaving? Something to consider if you’re thinking about leaving a job.
Workers who are younger than age 50 can contribute up to $20,500/year into their employer sponsored 401k plan. If you’re age 50 or older, you can contribute up to $27,000/year into your 401k. These are the contribution limits for 2022.
Roth IRA
Not everyone has access to a workplace 401k/403b/TSP plan. 33% of workers don’t have access to a workplace retirement plan, according to a 2020 report by the Bureau of Labor Statistics.
Heck, even people who do have access to a workplace 401k plan, may still choose to open a Roth IRA in addition to their 401k. They do this for a number of reasons
- IRAs have a lot more investing options than a 401k/403b
- If, for whatever reason, you need to withdraw a large sum of money at once while in retirement, pulling from a 401k could be heavily taxed. Withdrawals from a Roth IRA are tax free
- 401k plans have required minimum distributions (RMDs) starting at age 70.5. There is no such rule with a Roth IRA
Generally, people like to have both a 401k and Roth IRA for diversifying their options. For 2022, if you’re single and make under $129,000/year or $204,000/year if married, filing jointly, you can contribute the full $6,000/year into a Roth IRA. $7,000/year if you’re 50 or older.
Summary
A 401k is:
- An account, not investment (people usually choose a 3 fund portfolio or target date index fund to invest in inside the account)
- Employer sponsored
- Limited investment options compared to IRA (individual retirement account)
- May include an employer match (the employer match might take time to fully vest)
- Contributions limited to $20,500 per year for those under age 50. $27,000/year for those age 50 and older
- No penalty to access after age 59.5 years old
An IRA is:
- An individual retirement account, not tied to employer
- You can contribute to it as long as you have earned income
- Freedom to invest in large selection of things (unlike a 401k which has more limited investment options)
- You contribute to a Roth IRA with after tax dollars, so you can withdraw money after age 59.5 penalty-free and tax-fee
- Contributions limited to $6,000/year for those under age 50, single, and making less than $129,000/year